Ontario to scrap labour fund tax credit

(August 29, 2005) The Ontario government says it plans to introduce legislation that would eliminate the 15% tax credit for investors in labour-sponsored investment funds (LSIFs). No specific date was given, but in a statement, the province said the credit would be phased out no earlier than the end of the 2005 tax year.

“The LSIF tax credit was introduced when there was a need to kick start the venture capital sector in Ontario,” said Finance Minister Greg Sorbara in a statement. “Ontario’s venture capital market is much healthier now, and we believe that this incentive is no longer the best fit in today’s economic and fiscal climate.”

Sorbara noted that the federal government continues to offer a 15% tax credit on labour funds for investments of up to $5,000, matched by some provinces. “Investors continue to have the option to invest in labour-sponsored investment funds,” Sorbara said. “Our proposal would simply end the added Ontario incentive.”

Last year, the province imposed a moratorium on new labour funds, noting that “in the last several sales seasons, a number of newly registered LSIFs have failed to raise sufficient capital to be viable investment companies for the long term. LSIF capital is spread too thinly among too many LSIFs and many of the existing LSIFs are too small to be viable long-term investors.”

Industry observers predict today’s move by Ontario’s will have a negative impact on the already-struggling LSIF industry. First, it will dry up fundraising after the end of this year, says Dan Hallett of Dan Hallett & Associates, a labour fund expert who produces an annual report on the sector.

“In my opinion, removing half of the tax credit for Ontario residents will really diminish the attractiveness of the funds. While it’s true that a LSIF should be bought for its investment merit, the fact is that LSIFs incur costs to qualify for tax credits. Now, half of the credit will be gone while the investment constraints, strict regulations, and associated costs remain. Hence, it’s tough to justify new money being added to LSIFs — which is clearly the Ontario government’s intent.”

In addition, smaller funds will be under more pressure to cut costs, Hallett adds. “With the ability to raise more funds, fixed costs could simply be spread over a growing asset base. Now, asset base growth will get little if any help from inflows. And as shares mature, they’re more likely to be cashed in so there may be a slow decline in LSIF assets over time.” Hallett predicts marketing budgets will be cut and labour fund mergers will become more common.

Reaction from the LSIF industry to Ontario’s surprise move was also negative. “We are extremely disappointed in the government’s intention to phase out support to something as large and as important as the labour sponsor fund program,” says David Ferguson, managing general partner at Vengrowth, which runs the country’s two largest labour funds.

“Having the tax credit is an important incentive,” he says. “The eight-year-hold, which you need for this asset class, is a long time and investors want to be compensated for that period.”

Ferguson says while the elimination of the credit won’t affect Vengrowth shareholders, it could have a “profound” impact on the available supply of venture capital to the next generation of companies in Ontario.

“I think there’s also going to be a ripple effect because studies have shown that foreign venture capital won’t come in unless there’s a strong domestic market,” he adds.

“The province’s decision is ill-advised,” said Dale Patterson, executive director of the Association of Labour-Sponsored Investment Funds. “LSIFs have provided roughly 30% to 40% of Ontario’s venture capital over the past several years, and much of the rest is built on the previous financings of existing LSIF- backed companies. Without access to LSIF investment, the next generation of entrepreneurial firms will find it very difficult to attract capital.”

The province has pledged to give LSIFs more flexibility in the management of their portfolios as they plan their investment strategies going forward.

“Under proposed changes to investment requirements, the Ontario program would parallel the federal program by lowering the requirement to invest in eligible businesses to 60% from 70% of capital raised and remove investment requirements unique to Ontario’s program, such as restrictions on investments in public companies.

“In addition, the government will work with the LSIF industry and the federal government to assist with the transition from a provincial/federal program to a federal-only tax credit.”

Sorbara says the province will consult with the LSIF industry over the next few weeks on rules that will “help fund managers manage their portfolios, while ensuring that government spending is directed to priority areas.”

“We want to know how they arrived at this decision, because we are under-capitalized in the venture capital market as compared to the U.S.,” Ferguson notes. “We’re also going to tell him it’s the wrong decision, but beyond that we want to keep the credit in place as long as possible.”

According to Morningstar Canada, there are approximately 110 LSIFs in Canada. The 10 largest, led by Vengrowth, have more than $1.8 billion in assets.

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com

(08/29/05)

Doug Watt